What do you MEAN that my oil fund investment is actually a “large partnership?” And I can be AUDITED because of it?

Due to lower investment interest rates and correspondingly favorable provisions in the Tax Code in recent years, the “Master Limited Partnership” (or “MLP”) has often been the investment of choice for value seeking investors looking to find high yield at seemingly low risk. Sold by many financial advisers as “high yield funds,” many investors have absolutely no idea that their “fund” is actually a “large partnership” until such time as they are confronted with the tax reporting nightmare of recording the entity’s results. Even so, many investors elect to continue to hold MLP’s for a number of contemplated investment considerations, some of which are more muddied than ever due to the recent fall in oil prices.

Several years ago in our Newsletter, we had reported that the Government Accountability Office (“GAO”) stated that the IRS has failed to interact and efficiently audit “large partnerships,” which are defined as entities with 100 or more direct partners and $100 million or more in assets. The report was based on concerns that so called large partnerships have increased 47 percent since the last evaluation period. According to “Accounting Today” it was noted that in the 2012 tax year that “IRS field audits reviewed the books and records of only 0.8 percent of large partnership returns, according to the preliminary report.” Ostensibly, the auditing of less than 1 percent of these large partnerships is failing to cover mass amounts of money. Companies who bring in millions of annual revenue, such as MLP’s, are currently audit-free. More specifically, statistics show that 99 percent of these companies manage to be unidentified.

To the best of our knowledge and observation, MLP’s are not currently being set down for examination. However, once the GAO raises a concern, it is often followed by an effort on the part of the Treasury to sharply correct the same. Since MLP’s are known in the trade as “pass-through” entities, a change to partnership tax results for an open year under the tax statute will result in changes to the returns of the MLP unit holders for the same period. Translation: if an MLP that you own happens to get audited for a past year, you’ll have to amend your tax return and probably pay more tax. So much for these investments being deemed as “funds.”

But wait, there’s more!

During 2015, we had noted that several of the larger partnerships had a ratable pass-through for their investor-partners of “cancellation of indebtedness” income. In other words, a partnership ravaged by the poor oil market was unable to pay its legitimate debts. In this case the debtor, ostensibly seeing no possible way that their debt would ever be repaid, wrote the debt off. To this end, many limited partners of oil interests were forced to pay additional taxes on forgiven debts for which they were never responsible for!

To those veterans remaining in the field, many of us remember having to ask clients to pay back taxes in the late 1980’s for all of their “dog” tax sheltered partnerships that were audited in the days of unlimited (and often fabricated) write-offs. Then, as is now, many of these folks were surprised that the government could do such a thing, and the interest and penalties to be paid were often a shock. What they did not realize, but learned all too painfully, was that a partnership pays no income taxes. Howver, its partners do! The weeping and gnashing of teeth from that initiative was enormous.

But, where does all of this proceed today? Will MLP’s be audited? Will some of them report debt-cancellation income to their investors? None of us really know. As a dear friend and colleague of mine always says…. “Stay tuned to this station.”